Posts Tagged ‘Speculation’

The financial crash of 2008 was worldwide, and the failure of governments to address the causes of the crash also was worldwide. Because the same thing happened in different countries under different leaders, the reasons for failure are systemic, not just the personal failings of particular leaders. The solution must be systemic. A mere change in leaders is not enough.

John Lanchester, writing in the London Review of Books, wrote an excellent article about the crash and its aftermath. I hoped to call attention to it in my previous post, but, as of this writing, there has been only one click on the link.

I know people are busy and have many claims on their attention. If you don’t want to bother reading the full LRB article, here are some highlights. If you’re an American, bear in mind that, even though so much of what he wrote applies to the USA, his focus is on British policy.

The immediate economic consequence was the bailout of the banks. I’m not sure if it’s philosophically possible for an action to be both necessary and a disaster, but that in essence is what the bailouts were.

They were necessary, I thought at the time and still think, because this really was a moment of existential crisis for the financial system, and we don’t know what the consequences would have been for our societies if everything had imploded. But they turned into a disaster we are still living through.

The first and probably most consequential result of the bailouts was that governments across the developed world decided for political reasons that the only way to restore order to their finances was to resort to austerity measures. The financial crisis led to a contraction of credit, which in turn led to economic shrinkage, which in turn led to declining tax receipts for governments, which were suddenly looking at sharply increasing annual deficits and dramatically increasing levels of overall government debt.

So now we had austerity, which meant that life got harder for a lot of people, but – this is where the negative consequences of the bailout start to be really apparent – life did not get harder for banks and for the financial system. In the popular imagination, the people who caused the crisis got away with it scot-free, and, as what scientists call a first-order approximation, that’s about right.

In addition, there were no successful prosecutions of anyone at the higher levels of the financial system. Contrast that with the savings and loan scandal of the 1980s, basically a gigantic bust of the US equivalent of mortgage companies, in which 1100 executives were prosecuted. What had changed since then was the increasing hegemony of finance in the political system, which brought the ability quite simply to rewrite the rules of what is and isn’t legal.

Ten years after the financial crisis of 2008, the U.S. government has failed to do anything necessary to avoid a new crisis. I just read an article in the London Review of Books that says that the U.K. government’s policies are just as bad.

Like the U.S.-based banks, the British banks engaged in financial engineering that was supposed to create high profit on completely safe investments—which, as experience proved, couldn’t be done.

The British government had to bail out the banking system in order to save the economy. There probably was no alternative to that. But it then proceeded to put things back just the way they were before.

John Lanchester, the LRB writer, said there was no attempt at “ring fencing”—what we Americans call firewalls—to split up investment banks, which speculated on the financial markets, and retail banks, which granted small business loans, home mortgages and other services to the real economy.

The UK, like the US, engaged in “quantitative easing”—injection of money into the banking system through buying bonds. The basic idea was that if banks and corporations had more money to invest, they would invest more, and the economy would grow.

This didn’t happen. Instead banks and corporations bid up the prices of existing financial assets and real estate, which added to the wealth of the already rich.

Ordinary Britons faced austerity. Their government cut back on the social safety net and public services. British life expectancy, like American life expectancy, has actually fallen.

The British, like us Americans, had 10 years to fix their financial system. Like us, they wasted the opportunity. Now it may be too late to avert the next crash—even if the UK and US governments wanted to act.

In a well-functioning free enterprise economy, capitalists invest their wealth in ways that create new wealth, and thereby enrich society along with themselves. What’s going on now, as these charts from the German magazine Der Spiegel show, is that capitalists are using their wealth to bid up the prices of real estate and corporate stocks, which are rising faster than the overall economy is growing.

This is not limited to the United States. It is part of a worldwide pattern. The only way it can end is with another financial crash.

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. ==John Maynard Keynes

Double click to enlarge

Financial derivatives are a security not backed by any tangible asset. Buying and selling derivatives is no different from gambling. Notice how much larger is the market in derivatives than the market in stocks and bonds of actual companies.

The chart is from an article in Der Spiegel, the German news magazine. Der Spiegel says out-of-control world financial markets make another economic crash virtually inevitable.

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.

It seems paradoxical that while government is more intrusive than ever before into the lives of ordinary citizens, it gives free rein to powerful institutions and wealthy speculators to put the economy at risk.

Bart Chilton, commissioner of the Commodities Futures Trading Commission, gave interviews to The Real News Network describing how speculators and “dark markets” put the economy at risk, and drive up the prices of food and fuel.

Tyler Cowen is an economist on the faculty of George Mason University and the Center for the Study of Public Choice. He is an advocate of tax cuts and balanced budgets and a critic of Keynesian economists such as Paul Krugman.

Tyler Cowen

He wrote a disturbing article recently for The American Interest recently in which he argued that (1) the financial sector is soaking up increasing an increasing share of the U.S. national income and is likely to continue to do so; (2) by so doing it will put the U.S. economy increasingly at risk; and (3) it is hard to see what can be done about it.

He cited statistics showing how the financial sector is growing in comparison to producers of tangible goods and services. From 1973 through 1985, the financial sector never accounted for more than 16 percent of U.S. corporate profits; by 2004, it had risen to 41 percent. From 1948 through 1982, compensation of employees in the financial sector was roughly equivalent to average compensation in U.S. industry as a whole; by the 2000s, it was 181 percent.

Cowen noted that in 2004, the top 25 hedge fund managers received combined compensation equal to all the CEOs of the Standard & Poor’s 500 largest corporations put together. And the number of Wall Street speculators taking in (I won’t say earning) $100 million a year was nine times as great as the number of public company executives taking in that amount.

How did they become so rich? Cowen said it is by means of what he calls “going short on volatility.”

By this he means betting against infrequent events, such as a collapse of house prices, as if they were never going to happen. They are able to get away with this because, when the day of reckoning comes, they are able to walk away from the situation Wall Street firms are public companies, and so the risk of collapse is handed off to the shareholders. And they are so large and so entangled with the rest of the economy that the government can’t allow them to fail. Wall Street executives get to keep gains for themselves, while spreading risk to stockholders and taxpayers (and also to customers who buy securities they don’t understand, an aspect Cowen doesn’t deal with.)

Cowen doesn’t think there is much that can be done. The problem is not so much that the banks are too big to fail as that the bankers are too clever to be regulated. Their financial instruments and activities can’t be controlled because they are too complicated to understand. Whatever regulatory system the government tries to impose, Cowen thinks the so-called financial engineers will find a way to get around it.

For now, he says, the big financial institutions are chastened by the recession, and are inclined to sit on their money rather than gamble with it. The Federal Reserve System facilitates this by lending trillions of dollars at near-zero interest rates, on which the banks can profit by re-lending in the form of short-term commercial paper (money market funds). But sooner or later, he says, there will be another financial bubble.

The underlying dynamic favors excess risk-taking, but banks at the current moment fear the scrutiny of regulators and the public and so are playing it fairly safe. They are sitting on money rather than lending it out. The biggest risk today is how few parties will take risks, and, in part, the caution of banks is driving our current protracted economic slowdown. According to this view, the long run will bring another financial crisis once moods pick up and external scrutiny weakens, but that day of reckoning is still some ways off.

Is the overall picture a shame? Yes. Is it distorting resource distribution and productivity in the meantime? Yes. Will it again bring our economy to its knees? Probably.